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Chapter 09 – Business Organizations and Securities Regulation

Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968) (p. 416)

Syllabus

BarChris constructed bowling alleys. In 1961, it decided to raise some capital by selling bonds,

which required the filing of a registration statement with the SEC. When BarChris went bankrupt

in 1962, purchasers of the bonds sued various individuals, including officers, directors, and

outside auditors of BarChris. Several individuals attempted to establish due diligence defenses.

As to Russo, the CEO of BarChris, the court found he was “thoroughly aware” of BarChris’s

financial condition and could not have believed there were no untrue statements or material

omissions in the prospectus. Therefore, he had no due diligence defense. As to Trilling,

BarChris’s controller, although he was a comparatively minor figure at BarChris, he still must have

known of some of the inaccuracies. As financial officer, he was familiar with the company’s books

of account. He failed to prove he had made a reasonable investigation of the facts, instead relying

on others supplying him with accurate data. The court found this insufficient care given that

Trilling signed the registration statement. Auslander, an outside director, appointed to the board

after the initial registration filing, but before the final registration, also could not establish a due

diligence defense. He could rely on Peat Marwick’s expertise on the portions of the registration

statement, but he failed to do a proper investigation of the portions in which Peat Marwick Lacked

expertise—the type of investigation the court said a prudent man would employ in the

management of his own property. Finally, the court also found the outside auditors, Peat Marwick,

liable. The 1960 audit was mostly performed by Berardi, as his first job as a senior accountant.

He failed to find out that one of the bowling alleys was built, but had not been sold. In the words

of the court, “his S-1 review was useless.” He never even read the prospectus.

Answers to ‘Escott v. BarChris’ Questions (p. 419)

a. The financial statements were audited by Peat Marwick. Many of the defendants were found to

b. Russo, the CEO; Vitolo and Pugliese, founders, directors and members of the executive

2. No. The court stated, “[S]ection 11 imposes liability… upon a director, no matter how new he is. He

can escape liability only by using that reasonable care to investigate the facts which a prudent man

3. This can be a discussion based question. Ask the students to search the internet for different factors

that could make an audited financial statements ineffective. Depending on these factors students can

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Chapter 09 – Business Organizations and Securities Regulation

Basic Inc. v. Levinson et al. 485 U.S. 224 (1988) (p. 420)

Syllabus

Beginning in December 1976 Combustion Engineering, Inc. had meetings with Basic Inc.

concerning the possibility of a merger. During 1977 and 1978, Basic Inc. made three public

statements denying merger negotiations. Respondents are former Basic shareholders who sold

their stock after Basic’s first public denial but before the merger was announced in December

1977. They asserted violations under the 1934 Act prohibiting untrue statements of material facts.

On appeal, the issue was whether each respondent is required to prove his or her reliance on a

false statement, such that the false statement is causally linked to their injuries (sale of stock at

an artificially low price). The Court held that reliance could be inferred under a

fraud-on-the-market theory. This theory is based on the hypothesis that, in an open and

developed securities market, the price of stock is determined based on information available to

the market. Purchasers are defrauded by an artificially low price, as set by the market, even if

they themselves did not rely directly on the corporation’s misinformation. Held for respondents.

Answers to ‘Basic Inc. v. Levinson’ Questions (p. 421)

1. An item is material whenever there is “a substantial likelihood that the disclosure of the omitted fact

would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of

2. Yes, reliance is on a misrepresentation essential in a Rule 10b-5 action.

a. Plaintiff would face tremendous difficulty “proving” what they would have done had they known

the omitted information.

b. The Supreme Court adopted a presumption that the market price presented to potential buyers

SEC v. Texas Gulf Sulphur Co. 401 F.2d 833 (2d Cir. 1968) (p. 422)

Syllabus

In late 1963, Texas Gulf Sulphur (TGS) had drilling results in Canada that revealed the possibility

of having found one of the largest ore strikes in history. Shortly thereafter, insiders (on-site

geologists and certain corporate officers) began buying TGS stock on the open market at about

$18. Rumors of the strike gradually made their way around certain circles, but as late as April 12,

1964 TGS issued a press release denying the rumors. By April 16, the stock was trading for $36

when a Canadian government official made a public announcement of the estimated size of the

strike. By May 15, the stock price had exceeded $58. The SEC brought an insider trading suit

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Chapter 09 – Business Organizations and Securities Regulation

against those who had traded on the non-public information.

Rule 10b-5 prohibits anyone with material inside information from publicly trading in the subject

corporation’s stock for their own personal benefit. Their choice is either to disclose the information

to the investing public or abstain from trading or making recommendations to others to trade. The

Court found on these facts that the information withheld was material and that all transactions, by

individuals who had inside information on the drilling results, were made in violation of Rule

10b-5.

Answers to ‘SEC v. Texas Gulf’ Questions (p. 423)

1. You must either refrain from trading or you must disclose the information you have to the investing

public (so that the market can adjust the price—up or down—accordingly).

2. According to the Court in Texas Gulf, simply the occurrence of a public announcement is not

United States v. O’Hagan, 521 U.S. 642 (1997) (p. 424)

Syllabus

Respondent O’Hagan was a partner at a law firm which for a time represented Grand

Metropolitan in its potential tender offer of Pillsbury Company, although O’Hagan himself did not

participate in the legal work. While his firm was representing Grand Metropolitan. In August,

O’Hagan began purchasing Pillsbury stock options. He also purchased Pillsbury stock at $39.

When the tender offer was announced, the price rose to $60. O’Hagan sold, making a profit of

over $4.3 million. The SEC investigated and O-Hagan was convicted on securities fraud. On

appeal to the Eighth Circuit, the verdict was reversed rejecting liability under Rule 10b-5 under

the “misappropriation theory.” The Supreme Court granted certiorari. It is a permissible application

of Rule 10b-5 to hold that an individual committed securities fraud by misappropriating

confidential information, in breach of a duty owed to the source of the information, even if the

resulting stock trade was not in the securities of the source of the information. The Court found

that the misappropriator had gained advantage through deception and used it to trade in

securities. That was all that was required to find liability.

Answers to ‘United States v. O’Hagan’ Questions (p. 424–425)

1. This can be a discussion based question. The theories referenced are the “classical” and

2. Under the classical insider trading theory, the fiduciary relationship is with the corporation whose

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Chapter 09 – Business Organizations and Securities Regulation

3. Yes it would have made a difference because there would have been no breach of his duty of loyalty

and confidentiality.

Answers to Chapter Questions (p. 429)

1. To create a corporation, a promoter or an incorporator files articles of incorporation with the state

2. Found for Gries. If the business judgment rule applies, courts won‘t second-guess directors’

decisions. If it doesn’t, courts will apply strict scrutiny to determine whether the decision is

3. In the ordinary course of business, the act of any partner binds the partnership. If the motel had been

item of inventory, the partnership would have been committed to sell. However, the sale of motel is

a. The purpose of such a payout restriction is to incentivize a longer-term mentality in

management.

b. The logic here is that bonuses should be for superior performance and that superior

c. Delaware is widely known as a management-friendly jurisdiction. The argument is that

d. This can lead to a discussion. Such an approach would put a voice with a different viewpoint in

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Chapter 09 – Business Organizations and Securities Regulation

5. Reversed. The stock was a security. The “sale of business” doctrine did not apply. The instrument in

a. [These facts were “inspired” by WorldCom.] Bonds and other long-term debt of a company can

comprise an enormous portion of its balance sheet. While the debtor is not in breach of the

b. The Private Securities Litigation Reform Act of 1995 was intended to stop vexatious and

unwarranted securities litigation where fraud was inferred from the mere fact that a company’s

c. Under the provisions of the 1995 Act no fraudulent conduct— misrepresenting expenses as

assets—can be presumed from the simple fact that a security’s price dropped precipitously.

d. Section 10(b) (with its attendant Rule 10b-5) of the 1934 Act creates criminal liability for

defrauding market participants. The CFO has admitted to deliberately misrepresenting expenses

e. The SEC has the power to enjoin such persons from ever again serving as officers or directors

f. No, the SEC will not allow the CFO to keep the $10 million gain on the stock. The SEC has the

g. The SEC can impose civil penalties of up to $30 million (300%) with respect to the insider

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Chapter 09 – Business Organizations and Securities Regulation

Supplementary Material

I. Limited Liability Companies (p. 398)

Partnership, Corporation Aren’t Only Ways to Start Out

By Jeffrey A. Tannenbaum

Robert H. Kane’s start-up enterprise is a mouthful: Octagon Communications Limited Liability

Co. The name doesn’t exactly have a ring to it. It’s rather awkward on stationery and business

cards. It even fails to convey the company’s intended business: investments in rural

cellular-telephone companies. But loud and clear, the name conveys something else: a new

form of ownership that Mr. Kane and his seven partners expect will serve them well. Their

enterprise—to be based in Denver—is neither a traditional partnership nor a traditional

corporation. Rather, under Colorado law, it is a “limited liability company,” or LLC.

Mr. Kane and his partners expect to enjoy the best of both worlds: the tax advantages of a

partnership and the legal safeguards of a corporation. Yet they face none of the drawbacks

associated with forming a so-called subchapter S corporation, which also is taxed much like a

partnership. For example, S corporations can’t have corporate shareholders, but LLCs can. “If

some corporation ever wants to offer me jillions of dollars for my interest, I’ll be able to sell it,”

Mr. Kane says.

Growing Interest

Not yet worth jillions, Octagon doesn’t even have an office. But it is in the forefront of a

movement toward the LLC as a form of ownership for small U.S. businesses and joint

ventures. “Interest in the LLC concept is growing remarkably fast,” says John R. Maxfield, a

Denver lawyer who helped write the LLC law there.

Fast, anyway, by the slow-paced standards of lawmaking. In 1977, Wyoming became the first

state to authorize LLCs, but it took until 1988 for the Internal Revenue Service to confirm that

the new Wyoming entities would be treated as partnerships for federal tax purposes[.] “I’m

stunned by the amount of excitement generated by these entities,” says Barbara C. Spudis, a

Chicago attorney and the head of one ABA panel on LLCs.

One appeal of LLCs is that, as with partnerships, any income flows through untaxed to the

individual owners. Such owners don’t avoid personal taxes, but they do avoid corporate taxes.

And if the corporations pay dividends, owners are taxed again.

Flexibility of a Partnership

Of course, S corporations avoid double-taxation—but they don‘t enjoy all the advantages of

partnerships when it comes to juggling income and deductions. For example, the 20%-owner

of an S corporation normally must pay taxes on 20% of any income. By contrast, partnership

members are free to divvy up any income and tax liability as they see fit [.] LLCs offer the

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Chapter 09 – Business Organizations and Securities Regulation

same freedom. With LLCs, as with regular corporations, only the company’s assets, and not

the owners’ personal assets, are at risk in business-related lawsuits. In partnerships, so-called

limited partners enjoy such protection, but general partners don’t. And limited partners face

restrictions on how active they can be in the business. LLCs are designed to protect all

partners while imposing no limits on their activity.

Not surprisingly, lawyers in a few states say LLCs are an easy sell[.] Forming an LLC usually

costs $1,000 to $5,000 in attorney and filing fees, depending on complexity, says Mr. Maxfield,

the Denver lawyer. But some state programs have drawbacks. Florida LLCs are exempt from

federal corporate taxes but subject to the state‘s 5.5% corporate-income tax. Since Florida has

no personal income tax affecting partnership income, “that 5.5% is enough to scare people

off,” says Jose M. Sariego, a Miami lawyer. [L]awyers say it’s unclear how enterprises treated

as LLCs in their home states will be treated in states without LLC laws[.]

Benefit for Foreigners

[I]t’s ideal for foreign investors—normally barred from S corporations. LLCs don’t limit the

number or type of owners, as S corporations do, except for a two-owner minimum. But

because of other restrictions, only closely held enterprises are suited to be LLCs. For

example, if any owner leaves, the others must all formally agree to keep the enterprise going.

“If you have 200 members, it’s hard to get everybody to sign off on anything,” Mr. Keatinge

says[.]

The Wall Street Journal, May 14, 1991, p. B1. Reprinted by permission of The Wall Street Journal.

Selected Bibliography

Paul M. Barrett, “Justices Deal Investors a Blow in Certain Suits,” Wall Street Journal, April 20, 1994, p.

A2.

Karen Blumenthal, “Six Days in October: The Stock Market Crash of 1929” (Atheneum Books 2002).

John C. Coffee, Jr., “Outsider Trading, that New Crime,” Wall Street Journal, Nov. 14, 1990, p. A14.

John C. Coffee, Jr., Joseph A. Grundfest, Roberta Romano, and Murray L. Weidenbaum, “Corporate

Takeovers: Who Wins; Who Loses; Who Should Regulate?,” AEI Journal on Government and Society.

No. 1, 1988, p. 23.

L. Gordon Crovitz, “The SEC Overstepped When It Made Insider Trading a Crime,” The Wall Street

Journal, December 19, 1990, p. A17.

Edward Felsenthal, “Big Weapon Against Insider Trading Is Upheld,” The Wall Street Journal, June 26,

1997, p. C1.

Kathryn Graven, “Tokyo Moves Timidly on Insider Trading,” The Wall Street Journal, August 19, 1988, p.

12.

Lynne W. Jeter, “Disconnected: Deceit and Betrayal at WorldCom” (John Wiley & Sons 2003).

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Chapter 09 – Business Organizations and Securities Regulation

Arthur Levitt, “Take on the Street: What Wall Street and Corporate America Don’t Want You to Know”

(Pantheon 2002).

Charles W. Mulford and Eugene E. Comiskey, “The Financial Numbers Game: Detecting Creative

Accounting Practices” (John Wiley & Sons 2002).

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